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The Securities and Exchange Commission issued a report saying that the three major credit rating agencies have significant deficiencies in policies and procedures for rating structured products tied to subprime mortgages — including conflict-of-interest problems with their “issuers pay” fee model.

The report culminates a 10-month SEC examination of the three top credit rating agencies — Standard and Poor’s, Moody’s Investors Service, and FitchRatings.

No enforcement action against the agencies was announced by the SEC, although officials said that as a matter of procedure the examination staff discusses findings with the SEC enforcement division, to make the division aware of any potential violations.

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About 50 SEC staffers examined more than 100,000 pages of internal records and more than two million E-mail notes and instant messages, mostly related to two high-risk instruments: subprime residential mortgage-backed securities (RMBS) and collateralized debt obligations (CDOs). Collectively, these securities lost enormous value when homeowners began defaulting on their loans, and subsequently caused real estate and investment companies to take big write-downs, to lay off employees, and in some cases to shutter operations. In fact, significant exposure to subprime securities like RMBS and CDOs is what caused financial powerhouses such as Citigroup, UBS and Merrill Lynch to take writedowns in the tens of billions over the past year. Further, exposure to about $2 billion worth of RMBS and CDOs contributed to the collapse of Bear Stearns.

At a press conference today, SEC Chairman Christopher Cox noted that the “shortcomings” at the three agencies included issues related to the management of conflicts of interests, as well as problems with internal audit processes. Cox also said that the report, which covered the period from 2002 to 2006, revealed that rating agency employees “struggled” while trying to keep pace with the increasing number, and the complexity, of RMBS and CDO deals that have materialized since 2002. In fact, the report points out that as the deal volume increased, so did the revenues the firms derived from rating RMBS and CDOs, inferring that a conflict of interest in the issuers pay model exists.

Other deficiencies called out in the report include a lack of disclosure about the ratings process for RMBS and CDOs; substandard documentation of ratings policies and procedures; insufficient documentation regarding the rationale for deviating from models to adjust ratings; and lagging surveillance processes in updatin ratings, compared to “robust” initial ratings processes.

Although the SEC report did not tie particular deficiencies to specific agencies, it did release E-mail exchanges that underscored what Cox characterized as problems that were “boiling over” at the agencies. For example, in an E-mail exchange highlighting the pressure to adapt to the increase workload, one analyst complained to another that the firm’s model did not capture “half” the deal’s risk, while adding that the deals “could be structured by cows and we would still rate it.” In another exchange, an analytical manager in one agency’s real estate group wrote that, “staffing issues, of course, make it difficult to deliver the value that justifies our fees.”

Meanwhile, another E-mail note from an analyst in an agency’s CDO group quoted his manager as saying that the rating agencies continue to create an “even bigger monster — the CDO market. Let’s hope we are all wealthy and retired by the time this house of cards falters.”

Cox asserted that more evidence is needed to connect any one E-mail or instant message to specific problems, but said the “take away” from the report is that credit agency employees revealed “generalized concerns about laxity and stated norms” in their exchanges.

The report also found that while conflicts of interest exist in issuer-pays models, with respect to rating all asset classes, rating structured finance products, particularly RMBS and related CDOs, “may be exacerbated for a number of reasons.” For instance, the report cited how the deal arranger is often the primary designer, and therefore has more flexibility to adjust the structure to obtain a desired credit rating, compared to arrangers of non-structured asset classes. What’s more, arrangers that underwrite RMBS and CDO offerings have substantial influence over the choice of rating agencies hired to rate deals.

In addition, the report pointed out a high concentration of firms conducting the underwriting function, which in turn, concentrates the rating agencies revenue stream. Based on data provided by the three rating agencies examined in the report, the SEC reviewed a sample of 642 deals. Of those, 22 different arrangers underwrote subprime RMBS deals, and 12 of them accounted for 80 percent of the transactions, both in number and dollar volume. Similarly, for the 368 CDOs of RMBS deals, 26 different arrangers underwrote the CDOs, with 11 arrangers accounting for 92 percent of the deals and 80 percent of the dollar volume. Also, 12 of the largest 13 RMBS underwriters were also the 12 largest CDO underwriters.

At the press conference, the SEC did not release names of arrangers, but it noted that they were publicly available.

Cox explained that Congress addressed some of the problems cited in the report when it regulated credit rating agencies in September 2007, mandating the companies to register as nationally recognized statistical rating organizations (NRSROs). That subjected the agencies to certain disclosure and policy rules. Further, a set of proposed rules issued in June by the SEC, and currently out for public comment, address many of the remaining issues noted in the report.

For example, one proposed rule would prohibit agencies from issuing a rating on a structured product, unless information on the characteristics of the assets underlying the product was available to other credit rating agencies. This would allow other agencies to rate the product and potentially expose ratings that were influenced by the product’s sponsor. Another proposed rule would prohibit anyone participating in discussions about ratings fees to rate a product, while another potential rule would ban analysts from taking gifts amounting to more than $25 from issuers.

The SEC said that it has made several recommendations for remedial action, and that all three agencies have agreed to put the SEC’s recommendations into action.